Randall Hsu's  Instablog

I have to admit I am still learning to stay away from being one of theSpeculators.

It is not an easy task, since the boundary between speculation and investing is quite blurry.

So what's speculation? Again borrowing from Seth Klarman's script, "speculators buy and sell securities based on whether they believe those securities will next rise or fall in price". And, "their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others."

Speculators are a dominated force in today's market, and they are obsessed with predicting and guessing where stock is going the next moment. I am not saying speculators are bad, as there are many investment professionals who speculates and performed very well with their predictions. However, one important thing to remember is the results are short-term orientated. The speculators might be right today, but the earning is simply a deposit for what they might lose in the future if their predictions are no long valid, it's even more true if leverage is involved.

On the other hand, Investors "believe that over the long run security prices tend to reflect fundamental developments involving the underlying businesses". But how long is long-run? No one really knows, it can be 5, 10, or 25 years. With today's world, who is going to wait that long when everyone else is seeking instant gratification?

The human behavior of greed has driven major players on the market such as hedge funds, institutional funds, mutual funds, etc to become speculators which focus on beating the next quarterly result because that will attract new assets to invest in them.

We would think Internet would bring more validity towards the Efficient Market Hypothesis because the information are clear and readily available. In fact, we are seeing quite the opposite in 2008 with substantial volatility in all asset classes. It is very difficult for people to stay rational, especially during a panic time. Also, people's interpretation and predictions will always differ, with more information comes more predictions. Finally, the consensus prediction does not make itself correct, but these are a story for another day.

To be an investor is not as simple as one would think...

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

John Maynard Keynes said, "Markets can remain irrational longer than you can remain solvent." My biggest investment mistake was trying to go short on high-growth companies with rich valuations, such as Green Mountain Coffee Roasters (GMCR), Lululemon Athletica (LULU), and Deckers Outdoor (DECK). I learned that an individual security could remain overly pessimistic or optimistic for a period of time due to the market sentiments, and the best course of action is to focus on securities with depressed valuations and simply step away from securities with expensive valuations.

In the long run, the market is a weighting machine that should reflect an individual security's true worth, such as the recent revaluation of Green Mountain Coffee Roasters. However, by going short on a security, there are serious disadvantages making this operation unfavorable when compared to investing in a security with depressed valuations.

First, by going short, I have to borrow shares from other owners. This puts uncertainty on my holding period. I could be forced to cover in a short notice. Second, going short is subject to margin call. Unlike buying a depressed security with reasonable margin of safety, where a further decrease in price presents even better investment opportunity, shorting a security is subject to margin call when the price goes up, and I would be forced to cover my position instead of taking advantage of the situation. Finally, by going short, I have neglected the power of compound interest, which is the most effective method to building wealth.

Great investors like Warren Buffett did not try to short Internet companies during the Dot-com bubble. He focuses on companies that can reinvest profits at excellent rates over a long period of time, and this is a superior policy to allocating capital than going short.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

In addition to these three valuation metrics, Warren Buffett wrote in his recent annual letter that returns on unleveraged net tangible assets (ROUNTA) is a way to understand the competitiveness of a business, which makes it a better metric than ROA, ROE, and ROIC.

[ROUNTA Basic formula is: EBIT (1- tax rate) / (Equity + Debt - Intangibles)]

The basic premise is if two companies have the same tangible assets, the one that is able to earn a higher return may have economic goodwill, or sometime referred as an economic moat, within that business.

A business with high ROIC is fantastic, but high ROIC does not necessarily imply this business has strong economic franchise. For example, textile mills in the early 20th century enjoyed excellent ROIC, but it was mostly based on tangible assets that can be duplicated by other competitors in the long run.

In addition, companies tend to overpay for acquisitions. As a result, the combined entity will appear to have below-average ROIC due to goodwill and intangibles. However, it does not represent the true economics of the underlying businesses. ROA faces this issue as well.

Finally, a company with high leverage typically will have much higher ROE than a company with no leverage, but this advantage is a result of capital structure, instead of actual business performance.

Therefore, ROUNTA is the most informative metric but all metrics should be taken into consideration to have a better understanding of the business.

Below is a list of companies with above average ROUNTA and near their 52 weeks low. I will present a couple interesting companies in my next article for investment consideration.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.